“Positive adjusted EBITDA” has little to nothing in common with actually making money.
I would argue 99.9% of my clients operate on “adjusted EBITDA” for one reason or another. Now, I do work almost exclusively in the private equity portfolio company world where companies have clear ROI-driven objectives from ownership and those in charge of governance. Usually, when a company is acquired in the PE/VC context, it no longer exists to be a lifestyle business. Private equity folks aren’t (usually) interested in a “buy and hold forever” strategy. Usually, companies that get acquired by PE are on a 5–7 year hold pattern where an exit at the end for a multiple is the objective.
Everything that happens in the middle of that 5–7 year hold period is usually called “value creation.”
Value Creation
Value creation is generally the process of optimizing, enhancing, or even pruning areas within a newly acquired company to unlock embedded value and increase the overall market value of the company when a fund goes to sell it.
Value creation might involve:
- Pruning bloated overhead spend to increase profitability.
- Moving manufacturing in-house to achieve better unit economics on products (again, enhancing long-term profitability).
- Restructuring the management team to bring in industry experts who can take the company to the next level.
During these 5–7 year hold periods, financials are always tracked closely — the main metric being used to view profitability being EBITDA (earnings before interest, tax, depreciation, amortization). EBITDA is used as a baseline metric for general operating profitability. The key place where things start to derail from reality is in the concept of “add-backs” to this EBITDA baseline.
Add-backs
Certain expenses that PE owners/management deem as “non-recurring,” “won’t happen again,” “one-time,” or “this was only incurred for a growth initiative and now it’s gone” tend to be added back to baseline EBITDA to arrive at what is called adjusted EBITDA. This number is usually higher than reported, actual EBITDA.
Take normal operating profitability, inclusive of all the new spend and investments we’re making to grow the company during the value creation period, and add back any one-time expenses that skew or pull down profitability that might not be needed again — the goal with adjusted EBITDA is to show what a normalized profitability looks like in a go-forward steady state.
What’s ironic about claiming these “one-time growth expenditures” unjustly penalize profitability and subtract from showcasing true company performance is that the resulting adjusted EBITDA would not have been possible without these one-time expenses.
So, if year after year you are making investments to grow the business (as all businesses do regardless of being PE-owned or not), and your business does indeed grow, is normalized profitability the number stripping out all of that growth spend? Or is it the actual number required to get the business to its next growth inflection point? If every year, growing the business to the next level requires new or different levels of spend, I’d argue those really are recurring and are not one-time expenses that can be added back.
I’d argue you are a normal business like everyone else and need to cool it with the add-backs. But this isn’t how the private investment world usually looks at things.
So what?
Management operates the business solely to increase adjusted EBITDA, ignoring all of the one-time expenses that get added back (even though they actually leave the bank account). This methodology and operating framework inherently is divorced from actual money-making activities.
I see fewer management teams care (or even track) cash burn as one of their north star metrics after getting acquired by PE. Only when they’re almost out of cash do they really care or make an adjustment to spending habits.
One of my clients in the past had an actual EBITDA one year of -$2 million and an adjusted EBITDA of $500k.
How is this possible?
They had a lot of marketing agencies, legal help, operating costs, etc., they claimed were non-recurring, so were not a good indication of true operating profitability — so they added them back to say, “hey, we’re profitable!”
While I’d agree some of this might be true, generally speaking, this sort of spend occurred every year moving forward trying to grow top-line revenue and overall company size. This eventually ended up in a cash crunch and overleveraged position. Debt kept piling on to supplement and eventually take the place of equity capital so it wouldn’t be dilutive.
The owners didn’t want to put in more equity capital for fear it was too risky. They’d rather lock up the balance sheet of the company to try and boost their exit multiples using leverage.
That didn’t work — it was a very short-sighted view of operating a company to an exit rather than truly creating value for the long term.
The company ended up failing since they were chasing the wrong metrics. Management was trained to make big, strategic decisions based on “fake profitability.”
Time and place for reported EBITDA, adjusted EBITDA, and cash burn
There is indeed a time and place for each of these metrics. Each of them tells us something different. But none of them can be used in a vacuum.
You MUST understand how adjusted EBITDA relates to cash so you can balance the investor’s view of profitability (and ultimately company market value) versus the actual operations of the company and keeping cash flow healthy so you can exist for the long term.
Like my old client, you absolutely can be “adjusted EBITDA-positive” but hemorrhage cash like there’s no tomorrow. If you actually want to win the value creation game, keep a pulse on:
- Adjusted EBITDA (…since this will never go away).
- Reported EBITDA (what is your company actually doing operating profit-wise?).
- Cash burn (historical, trending views: last 12 months, last 3 months, etc.).
- Cash forecasts (what will cash balances be in 8–12 months after we deploy some of this new investment money?).
